Tuesday, August 31, 2010

I have been making a lot of noise here about the Fed's passive tightening of monetary policy. In particular, I have been pointing to declines in both inflation expectations and forecasts of nominal GDP (NGDP) to show that the Fed is allowing expectations of future aggregate demand (AD) to fall. Since future spending affects current spending, current Fed policy is also effectively slowing down current AD. Given this running discussion of mine, I thought it would be interesting to see what my undergraduate students think about it. Specifically, what is their outlook for AD? On the first day of class I assign a personal profile sheet they have to fill out--helps me get to know them better--and this semester I added a question that asks them to forecast of the annualized NGDP growth for 2010:Q3 and 2010:Q4. I gave them a chart of the annualized NGDP figures of the previous 6 quarters and and told them to use it and their knowledge of what is happening to make their forecasts.

Since these are undergrad students mostly from Texas, a state that hasn't been hit as hard by the recession, and since many undergrads are not as engaged with the current events as they should be I expected rather optimistic forecasts. Here is what I got from my three classes (click on figure to enlarge):

Much to my surprise my students overall see an ongoing downward trend in the growth rate of nominal spending. All of their 2010:Q4 forecasts are lower than that coming from the Survey of Professional Forecasters. I really expected more optimistic numbers. Maybe they simply followed the trend from the previous quarters in making their forecasts or maybe they truly are worried about the future. I look forward to class today to hear their justification for their forecasts. I also look forward to seeing how their forecasts pan out compared to the professionals during the semester.

Friday, August 27, 2010

Ben Bernanke delivered a much anticipated speech today at the Jackson Hole Economic Symposium. Many observers, myself included, were wondering if he would advocate a more aggressive role for monetary policy given the signs of weakening in the U.S. economy. Instead, what he delivered was a big tease: he acknowledges three points made by advocates of more monetary easing, but then either ignores the implications of these points or argues against them.

Let's look at the three points he acknowledges in turn. First, he concedes that the low interest rates can reflect a weak economy rather than being a sign of loose monetary policy. Second, he grants that the Fed can be effectively tightening monetary policy simply by being passive. He makes these two big concessions in his discussion of why the FOMC decided to stabilize the Fed's balance sheet (my bold):

[A]llowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any furtherweakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.

Consider the implications of these points. First, if lower interest rates reflect economic weakness--though he mentions long-term interest rates recall they are the expectation of a bunch of short-term interest rates plus some term premium--then one implication is that the low federal funds rate may not be so accommodative after all. Given the state of the economy, maybe the 0%-0.25% range for the federal funds rate is not low enough. Now the federal funds rate cannot go negative (and this is one of the problems with using an interest rate target), but if it could the implication here is that it may need to go deep into negative territory in order to be at the appropriate level. Folks like Andy Harless and Glenn Rudebusch have made this very point. So what does Bernanke think? Does he run with his own argument to its logical conclusion? The answer is no. Elsewhere in the speech he claims that "monetary policy remains very accommodative" and that the "Fed has also taken extraordinary measures to ease monetary and financial conditions. Notably,... the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points..." In short, Bernanke thinks the low federal funds rate is sufficiently accommodative, even after acknowledging that low interest rates can reflect weak economic conditions rather than loose monetary policy.

Now consider his second concession: the Fed can effectively be tightening monetary policy just by being passive. He acknowledges this point in the context of stabilizing the Fed's balance sheet. This is an important insight, but what about the other ways the Fed can passively tighten monetary policy? Currently, the Fed is failing to stabilize the NGDP or aggregate demand forecast. By allowing this to happen the Fed is effectively tightening monetary policy. Why is he not concerned here too about such passive tightening of monetary policy?

Bernanke's third concession is an important one too. In his discussion of what the Fed can do if more action is required, he alludes to the idea of price level targeting. Now this option is not as good as NGDP level targeting, but it would be vast improvement over what is going on. Here is what he said:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability... in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

He is absolutely right that a price level target would mean higher than normal inflation currently to get the economy back to its previous price level path. If such a price level target were formally announced, it would go a long ways in (1) creating more economic certainty and (2) helping household balance sheets repair themselves. So is Bernanke on board? Unfortunately, for two reasons the answer is no. First, he sees no support for such a policy in the FOMC . And, apparently, this is one battle he does not want to fight at the Fed. Second, and more troubling, he does not think it is needed and believes it could even be problematic:

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy

This is perplexing on so many levels. First, an explicit price level target would not destroy long-run inflation expectations. Yes, there may be an inflation catch up period, but over the long-run the inflation rate would be governed by the inflation rate implied by the price level target. (Of course, an even better solution would be targeting a NGDP level, but I digress.) Second, for the 100100 time, inflation expectations are not stable or well anchored. The have been falling all year across all horizons as can be seen with the Clevend Fed data . This sustained decline can also be seen below on a daily basis for the five-year horizon:

How can there be any question about falling inflation expectations? (For those concerned that the liquidity premium is distorting the implied expected inflation rate from the Treasury market note the following. First, the Cleveland Fed data corrects for this potential distortion. Second, even in the case of the chart above a heightened liquidity premium only reinforces the likelihood of growing deflationary pressures. This is because a heightened liquidity premium implies a heightened demand for highly liquid assets like treasuries and money. In turn, this implies less spending and greater deflationary pressures.) Third, if there is anything driving increased uncertainty it is a weakening economy. And by failing to stabilize inflation expectations, the Fed is allowing economic uncertainty to grow. Bernanke seems hung up on a potential source of economic uncertainty instead of looking to an actual source of economic uncertainty.

Monday, August 23, 2010

Fiscal and interest rate ammo has been exhausted, though not QE. I have little doubt that central banks can lift the West out of debt-deflation if needed with genuine QE – not Ben Bernanke's Black Box "creditism", or Japan's fringe dabbling. Whether they have the nerve or the ideological willingness to do so is another matter.

Friday, August 20, 2010

The tragedy unfolding in Pakistan is mind boggling. Robert Reich discusses why you should be concerned about it:

Flooding there has already stranded 20 million people, more than 10 percent of the population. A fifth of the nation is underwater. More than 3.5 million children are in imminent danger of contracting cholera and acute diarrhea; millions more are in danger of starving if they don’t get help soon. More than 1,500 have already been killed by the floods.

This is a human disaster. It’s also a frightening opening for the Taliban.

Recently I noted that aggregate demand forecasts are falling. Well today I learned that it gets worse: aggregate demand is already falling! Macroeconomic Advisers just updated its monthly nominal GDP series, a measure of aggregate demand, and it shows a decline for May and June as seen below (click on figure to enlarge):

I shouldn't be surprised with these numbers since expectations of future economic activity affect current spending decisions and for some time expectations have been deteriorating. Still, I was shocked to see the outright decline in May and June. Let's be clear what this development means: total current dollar spending declined during May and June in the U.S. economy. And most likely it continued to fall in July and August given the weak economic outlook. This makes me wonder how low the dollar size of the U.S. economy must go before the Fed gets serious and pulls out its big guns?

Thursday, August 19, 2010

Building upon Christopher Hayes' metaphor of central banking as farming, Neil Irwin shows that some of the issues in implementing unconventional monetary policy can be tricky since no one at the Fed has ever tried them before. Fed officials are reluctant to act because they are uncertain of the outcome. Here is Irwin:

If the nation were a farm, Hayes argued, the Fed would be the agency in charge of water and irrigation. Its job is to keep water (money) flowing enough to maximize crops (strong job creation), but not pump in so much water as to cause flooding (inflation). We're currently in an extreme drought (a deep recession), but the Fed is refusing to pump in more water because it's afraid that doing so will cause flooding down the road.

This drought is so bad that the Fed has already drained its main reservoir completely (cut the federal funds rate to zero). So if it's going to take new efforts to water the fields, it has to find more water through some unconventional means, such as by airlifting water in by helicopter, or piping it in from a nearby lake. (These are the equivalents of quantitative easing, or buying Treasury bonds and other securities to increase the money supply and drive down long-term interest rates).

The problem is, while the Fed has lots of experience and knowledge about how the controls on its normal reservoir work, and how much to open the valves to get the right amount of water onto the fields, these other tools are untested. If they pipe water in, they're not sure how much will get to the fields--it might be too little to do much good, and it might be so much as to cause flooding.

That is a good point, but it certainly did not stop farmer Bernanke and all his farm hands from flooding the financial fields with large scale "credit easing" in 2008-2009. I am sure there was plenty of uncertainty back then about conducting "credit easing", but the sense of urgency overrode this concern. Likewise, if there were enough urgency today the Fed probably would not hesitate to do more unconventional monetary policy. The real question, then, is why the lack of urgency?

Wednesday, August 18, 2010

Ten years ago we experienced the biggest bubble in U.S. stock market history.... A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.... We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic....

While they may be right that bond prices have gone up because of economic pessimism and the associated low interest rates, there is good reason for the pessimism. It's called a recession, not just any recession but a balance sheet recession. The balance sheets of households in particular have deteriorated so much they are back to where they were about 20 years ago. It will probably take years to heal household balance sheets. If so, there is little reason to believe there is going to be a robust economic recovery anytime soon that will push up interest rates and cause bond prices to crash. The importance of weak household balance sheets cannot be overstated. It is the main reason why the federal government balance sheet is currently growing (i.e. the contraction of household balance sheets is being offset by the expansion of the government balance sheet) and therefore is, in part, indirectly responsible for all the concerns about exploding fiscal deficits. Siegel and Schwartz try to dismiss this concern by saying the problem is overstated but I don't buy it. Neither do the economists in the Survey of Professional Forecasters. They see a weak recovery at best at least through 2011. Even if one accepts Siegel and Schwartz's view that there is excessive pessimism in the market it is still hard to talk about bubbles in the bond market like on does with the stock market as noted by Brad DeLong.

In short, there is economic weakness a far as the eye can see and this suggests interest rates will probably be low for an extended period of time. Therefore, even if we do have a bond bubble it is not going away anytime soon. As Colin Barr says, for now we may be stuck with an unpoppable bond bubble.

For some time I have been making the case that the sustained decline in inflation expectations is indicating the market is expecting aggregate demand to decline going forward. Given the Fed's failure to meaningfully respond to these forecasted declines, I have also claimed these developments effectively amount to a tightening of monetary policy. This interpretation, however, can be challenged because inflation is a symptom of changes in aggregate supply and aggregate demand. Thus, inflation expectations could be going down because productivity growth has been robust rather than from a decline in total current dollar spending. My view that it has been an expected weakening of aggregate demand driving the declines in inflation forecasts has been based more on circumstantial evidence than any direct measures of aggregate supply or aggregate demand. Recent data releases, however, now firmly support my view. First, nonfarm business labor productivity declined at annualized rate of 0.9% in the 2010:Q2. No positive aggregate supply shocks here. Second, the just released Survey of Professional Forecasters shows a marked drop in the forecasted growth rate of aggregate demand over the next year as measured by nominal GDP (NGDP). This drop is graphed below and shows the NGDP forecast made in May, 2010 and the NGDP forecast made in August, 2010. (Click on the figure to enlarge.)

Here, the forecast for 2010:Q3 takes an alarming drop, going from a forecast of about 4.50% growth in May to a forecast of 3.24% in August. The Fed, therefore, has allowed NGDP forecasts to fall by 1.26% over these two quarters. Does that make any sense in the current economic environment? Does the Fed not realize that by passively allowing such developments it is effectively tightening monetary policy? I wish I could have a one-on-one with some of the Fed officials and ask them to explain to me their indifference to these developments.

So it is happening: aggregate demand forecasts are falling. And unless the Fed arrests this development it could get worse. Hopefully the FOMC's decision last week to stabilize the Fed's balance sheet is an indication that it is begining to take notice of these warning signs.

PS. This crisis has really driven home to me the need for a NGDP futures market. Why does no such market exist?

PPS. The above discussion highlights the importance of being careful in interpreting inflation. In general, I don't think we should spend so much time looking at inflation but rather focus on the underlying causes of inflation: shocks to aggregate demand and aggregate supply. Monetary policy can only stabilize the former and should avoid responding to the latter. A pure inflation target, however, ignores this distinction and has the potential to increase macroeconomic instability as shown here. That is why I favor a NGDP target over an inflation target.

Measures of underlying inflation have trended lower in recent quarters and with... longer-term inflation expectations stable, inflation is likely to be subdued for some time.

How can the FOMC claim inflation expectations are stable? Bernanke made the same puzzling claim in his last speech which prompted me to do my last post. What inflation forecast is the FOMC using? One would think that the conservative bond market with billions of dollars on the line would be the best place to get an inflation forecast.

Update: I should have mentioned that the forecasted values above are the averages of all the individual economic forecasts provided by the economic forecasters to the survey.

Tuesday, August 3, 2010

Many observers, including myself, have been puzzled by the Fed's lackofurgency in recent months over the apparent slowing down of aggregate demand. The one thing monetary policy is capable of doing is stabilizing total current dollar spending, but it isn't and this inaction effectively amounts to a tightening of monetary policy. There have been many reasons given for this seeming complacency by the Fed: internal divisions over policy, fear of political backlash, opportunistic disinflation, fear of awakening bond vigilettentes, and sheer exhaustion. Another potential reason is that the Fed simply doesn't see this aggregate demand slowdown in the data. I actually considered this possibility some time ago but never put too much weight on it since this is the Federal Reserve after all. It has far more resources than I do and surely sees what I see in the data. However, after Fed Chairman Ben Bernanke's speech yesterday I am beginning to wonder if the Fed is actually missing something in the data. In particular, I was stunned to read this sentence in the speech:

Meanwhile, measures of expected inflation generally have remained stable.

Uhm, unless I have been living in parallel universe and just got phased into a different one this statement is completely wrong. Inflation expectations, as I show below, have been persistently declining since the start of 2010. Not only that, but Bernanke's claim that inflation expectations are stable has huge policy implications. It is widely understood that expectations of future inflation are a key determinant of current aggregate demand. If expectations of inflation are stable as Bernanke claims then aggregate demand growth should also be relatively stable. On the other hand, if inflation expectations are falling and have been doing so for some time as I claim then it is likely that current aggregate demand growth also has been falling.*

If Bernanke really believes inflation expectations are stable then one must give him credit for implementing monetary policy in a manner consistent with that understanding. However, I simply cannot understand how he or anyone else at the Fed could hold such a view. The best indicators of inflation expectations have been screaming red alert for some time now. How the Fed could have missed this red alert is unfathomable to me, but on the off chance that they have and are reading this post I ask that they please take note of the following set of figures.

The first figure shows the term structure of expected inflation over the first half of 2010. The plotted curves in the figure show the average expected inflation rate at various yearly horizons for the first six months of 2010. The data comes from the Cleveland Fed. This figure makes clear that inflation expectations have been trending down across all horizons since the start of the year. Note that the 1-year horizon has seen inflation expectations drop by about 100 basis points. (Click on figure to enlarge)

Now to put this figure into perspective let's look at the term structure of inflation expectations the last time expected inflation fell rapidly and caused aggregate demand to tank. Yes, that would be the late 2008, early 2009 period. Here is the figure for this time. Notice any similarities? (Click on figure to enlarge.)

Here too we see a decline across all horizons with the 1-year having the sharpest decline. Now current inflation expectations have not fallen as much as these above but they are persistently falling. And we know from the late 2008, early 2009 experience what happens to aggregate demand when inflation expectations are allowed to continue to fall: you get the greatest decline in nominal spending since the Great Depression.

Now the dire picture painted by the Cleveland Fed data is wholly corroborated by the inflation expectations implied by the the difference between the nominal interest rates on regular treasury securities and the real interest rates on treasury inflation protected securities (TIPS). This measure of inflation expectations is graphed below using daily data on 5-year treasuries for the period January 4, 2010 - July 29, 2010: (Click on figure to enlarge.)

Here again there is a clear downward trend. Inflation expectations are falling and there is currently no end in sight. Given all of this evidence, how can Ben Bernanke assert that inflationary expectations are stable? I am truly bewildered by that claim. I hope Fed officials who have read this far are also bewildered and are now reconsidering their views. Let me be very clear what all of this implies: by failing to stabilize inflation expectations the Fed is effectively tightening monetary policy at a most inopportune time. I hope this is not how the Fed wants to be remembered.

The comparatively resilient Texas economy continues to draw attention. Following earlier pieces by The Economist and CNN/Fortune, the Atlantic has a new piece grappling with the economic phenomenon that is Texas. What makes this discussion really interesting is when the Texas numbers are matched up against the other big states, particularly California. And it is always interesting to see Texas compared to Michigan, which seems to be its mirror opposite on many levels. Maybe the relatively good economy in Texas explains in part the reluctance of Dallas Fed President Richard Fisher to call for more aggressive monetary policy action to counter the effective tightening of U.S. monetary policy.

Some Other Writings

About Me

I am an assistant professor of economics at Western Kentucky University in Bowling Green, Kentucky. I am using this blog as an outlet to express my ideas, concerns, and questions on macroeconomics and markets.